Volatility is a good measure for risk.
Volatility measures volatility, not risk. True risk is permanent loss of capital.
Volatility as a measure of risk has been popularized by academics, based on a fundamentally flawed underlying philosophy. Most academics view stock prices as mostly efficient, and they believe that any future price changes occur solely due to unknown and unknowable future events. Based on this philosophy, future price “surprises” are equally likely to be in a positive or negative direction, as everything already known or forecasted is already “priced in”. A higher risk stock is one with a hazier and more uncertain future, whose price jumps around more (in both directions). A lower risk stock is one with a relatively stable and certain future, whose price therefore is relatively stable. In this view, volatility equals risk.
As committed value investors, we reject the Efficient Market Hypothesis in toto. Stock prices are often wildly wrong. Just look at the dramatic swings from 52-week highs to lows found on most stocks, far in excess of any imaginable real change in the prospects of the underlying business. As value investors, the whole point of investing is to focus on the gap between share price paid and intrinsic value received, i.e. to buy undervalued companies. From a value investing standpoint, the risk we must focus on is not the ephemeral risk of volatility. The true risk we must focus on is the risk of fundamentally misvaluing a company and paying a price in excess of intrinsic value.
Investors need to worry about volatility.
A long-term investor should focus on the long term, not on short-term price swings.
As a practical matter, short-term price swings can still matter to a trader or a short-term speculator. If a stock moves against them, they will bail and lose money; they are not in it for the long haul. But as committed long-term value investors, we are not concerned with short-term price swings. We are invested for the long term and view price drops as potential opportunities to buy quality companies even more cheaply. We are laser-focused not on managing the “risk” of volatility, but the true risk, the risk of permanent loss of capital due to fundamentally misvaluing the underlying business.
The way to deal with risk is through diversification.
Diversification is often di‑worsification. The correct way to deal with risk is understand your investments thoroughly and to only invest with a large buffer between price paid and value received.
This misconception is a corollary of the previous ones. By assuming prices are efficient, academics place emphasis on diversification to balance the idiosyncratic risks of each sector, geography, or individual company. As value investors who labor to discover undervalued companies, we specifically focus on the idiosyncratic differences which turn specific companies into special investment opportunities. We do not want to diversify away our sources of superior long-term returns. In fact, diversifying too much will just mean spreading yourself too thin, increasing the risk of misunderstanding the investment and misvaluing the company.
The correct way of handling risk is to bake risk management into the investment process underlying each individual investment. The three basic pillars of risk management in choosing an investment are: Circle of Competence, Deep Research, & Margin of Safety. Circle of Competence means to only invest in those areas and sectors which are within your circle of competence, those areas which you are capable of properly understanding and analyzing. If the accounting is too obscure, or too much data is missing, or the technical details are over your head, or you otherwise just can’t understand what makes the business tick, then you shouldn’t be considering that investment. Deep Research means to not only be capable of properly understanding and analyzing the investment, but to actually put in the necessary time and effort to deeply and thoroughly research every aspect of the business, the industry, its competitors, etc., until you understand everything about the investment. Margin of Safety means that after everything is said and done, you should only invest in companies that provide you a large margin of safety, companies that are deeply undervalued. By leaving yourself a large buffer, if your analysis is indeed wrong or unexpected black swan events occur, you still have a decent chance of coming out ahead.
Reaching for higher returns necessitates taking more risk.
In value investing, higher returns go hand in hand with lower risk.
Although there are styles of investing which embrace more risk in their quest to boost returns, value investing is the polar opposite. In value investing, the process which produces superior returns is the very same process which actually lowers risk. Buying deeply undervalued companies at a deep discount to intrinsic value is the source for the superior returns of value investing. And the very same buying deeply undervalued companies at deep discounts to intrinsic value is the Margin of Safety that lowers risk.
You can ever truly enumerate and account for all the possible things that can go wrong.
There will always be something that you didn’t anticipate or expect. Only invest in companies that have the resilience and wherewithal to manage through the unexpected.
Every stock market crash is different from the one before it, and market participants always seem to be fighting the last war. New fault lines that no one expected explode out of nowhere, and the way to deal with risk is not to try to account for every imaginable risk individually. You will not be able to do so, and you will still probably miss the risk that ends up being the important one for that market cycle anyways. The correct way to deal with risk is to bake risk management into the investment process for each individual position, by focusing on companies that are Predictable and Resilient. Predictable companies are companies that are more stable, with less moving parts, that will throw you fewer curveballs. Resilient companies are companies that have the wherewithal and strength to survive and thrive through the inevitable minor and major earthquakes that will unexpectedly occur. Among other things, this includes having a strong balance sheet and financial strength, high margins and operating strength, and a good management team and execution strength.
Risk can be adequately judged by looking at past results.
Risk can only be judged by understanding the complete investment process from beginning to end.
Looking at past results often shows success after success with a system that always works…until it doesn’t. History is littered with the corpses of strategies that “couldn’t” fail and would “always” work (LTCM anyone?). Quite often, when it eventually blows up, the strategy loses more money on the way down than it ever made on the way up. To judge risk management, you cannot just look at past results and quantitative metrics. You have to understand and be comfortable with the investment process being used and how risk is being managed.
